Modern monetary theory, negative interest rates, and Paul Krugman

April 21, 2011

Yet another post today, spurred on by Andrew Bell’s pertinent comment (#1) to my earlier post on hoarding and its seeming relevance to Paul Krugman’s objection, expressed again today, to Modern Monetary Theory (MMT). In the post, I argued that much of our economic problem arises from the failure of wealth holders to re-circulate their accumulated purchasing power in productive investments. Instead of productive new investment, we see massive hoarding, a near exclusive devotion to mergers and acquisitions, and idle gambling in the global financial casino. I concluded that we should give wealth holders a choice, either invest productively or we should invest for them.

Andrew pointed out a straightforward means of doing this using what could be considered monetary policy:

1. Limit real dollars (cash money)
2. Require all dollars held by banks to be associated with a SSN or suitable ID that shows ownership (that pretty much already happens).
3. Tax dollars in accounts at a rate related to the number of dollars in all bank accounts of any entity on a daily/weekly basis – whatever. Make it expensive to hold dollars to encourage people to spend them.

This is essentially a negative interest rate on non-productive assets. It’s an excellent idea that’s been around for quite a while and was supported by no less an authority than Keynes in his “General Theory of Employment, Interest, and Money”. A capitalist economy requires the continuous circulation of money and will inevitably collapse without it. Great inequalities of income are permitted, (to which I greatly object), but the implied bargain is that the wealthy are responsible for directing society’s investment. They are shirking a solemn commitment if they fail to adequately invest.

I don’t think the negative interest rate idea is actually that radical. All communities in the US have a substantial tax on real estate and some, like Colorado, on autos. These are the only two major investments of the working class and, not too surprisingly, they’re subject to a “wealth” tax. It’s extraordinarily high, in fact, since the tax is on the gross value of the asset and not on the equity portion. If the two major assets held by the working class are subject to a wealth tax, why shouldn’t all other assets? Why a tax on a home and not stocks and bonds?

There are three ways the private sector can spend: consumption, productive investment, and non-productive “investment”. Many economists and politicians call for taxing consumption but wouldn’t it be much better to tax non-productive “investment” when such a tax would be so beneficial?

How does MMT and Paul Krugman fit into this? MMT is not so much a theory as a statement of some fairly obvious facts. All modern currencies are fiat in that they aren’t backed by gold or any other commodity. The issuing government can create its own currency at will and without cost. It therefore has no need for taxes or borrowings and these operations should therefore be seen for what they are: monetary operations which either destroy money (taxes) or drain reserves (borrowings). MMT proponents argue that governments are constrained only by the capacity of the economy. Spending beyond that level would be inflationary but deficits in themselves have no importance.

Paul Krugman is essentially a monetarist who believes interest rate policy can solve most problems – that is until rates fall to zero at which time we are in a “liquidity trap”. Then and only then should governments consider fiscal deficits. As I understand it, he objects to MMT because bank reserves could increase to such a level that interest rates will be stuck at zero and the government would lose its ability to increase rates as the economy strengthens.

The negative interest rate idea seems a strong answer to Krugman’s concern. Let’s say we implement a 5% surcharge on all non-productive investments. One would expect productive activity to greatly expand as hoarding became quite expensive. If it didn’t, then the surcharge could be increased. When / if full employment is reached, the Fed would want to limit further expansion and one way to do it would be to offer a less negative deposit facility. This would slow new investment to the same degree as increased interest rates but without the noxious and highly regressive risk free return to wealth. This example, I think, further clarifies the point that borrowing is not a means of funding government spending but is instead a monetary operation. There’s no reasonable way that the hypothesized deposit facility could be considered a burden to future generations or an unsustainable debt that must be reduced. It’s simply a means to withdraw funds from the active economy.

What if a zero rate deposit facility wasn’t enough to slow investment? In such instances, one could increase bank reserve ratios or institute a reserve requirement on holders of great wealth. The key point is that Krugman’s fear of losing the monetary policy tool is grounded on very inside the box thinking.

Some will fear such a program would lead to a sharp decline in the currency or the exit of business from the country. It would be infeasible for a small country to attempt this but it’s very practical for a continent sized economy like the US. A negative interest rate is a tax on capital and like any such tax could cause some to flee. But are we to argue we should avoid taxes on wealth? And it would be quite risky for businesses to flee given the option of high tariffs and the very important reality that they couldn’t take the technological knowledge with them. By far the best solution though would be concerted action among the major economies.

It’s far from solving all our problems, but I think a surcharge on non-productive “investment” would move us a valuable step closer to democracy.

“…Applying the historical Taylor rule right now, with inflation very low and unemployment very high, would mean that the Fed’s main policy rate, the overnight rate at which banks lend reserves to each other, should currently be minus 5 or 6 percent. Obviously, that’s not possible: nobody will lend at a negative interest rate, since you can always hold cash instead…”

His focus was on lenders (re. the need to get credit flowing again). In addition, he uses the term ‘negative interest rate’ as an analog for inflation – when the purchasing power of money is declining, it’s as if your savings are reaping a negative interest rate.

The proposal being made here is not a universally applicable interest rate, only idle money would face the surcharge. It might be less confusing to give it another name. I was surprised to find that Krugman is said to have supported a ‘negative interest rate’ for Japan – but again, its just code word for wanting to create inflation to get money holders to spend.

A surcharge is probably a clearer term than negative interest rate. It is interest like, though, since it represents a carrying cost for money. I also used the negative interest rate term to try to link it with Krugman’s objection to MMT and show that there was still space for interest rate policy.